چکیده انگلیسی

This paper explores how a monetary regime change affects headline inflation via differential effects on various sectors in the economy. Using disaggregated CPI data for Canada, we find that the response to the adoption of inflation targeting (IT) was quite heterogeneous across sectors. While sticky-price sectors experienced a notable change in inflation dynamics following IT adoption, little structural change was observed in flexible price sectors. Our analysis based on a common factor model suggests that the structural changes in the sticky price sectors are driven by a decline in their responses to common aggregate shocks, including a monetary shock.

مقدمه انگلیسی

It is widely recognized in the literature that monetary policy regime shifts have been key contributors to the evolution of headline inflation in major industrialized countries (e.g. Benati, 2008 and Cecchetti et al., 2007). Despite extensive research on the effects of these regime changes on macroeconomic performance, not much is known about the channels through which they are transmitted to headline inflation. Recent research highlights the importance of understanding the heterogeneous behavior of subaggregate inflation, and so studying sectoral-level responses to a regime change appears to be a promising avenue of investigation. Given that a growing body of research looking at the microdata generally suggests that inflation dynamics differ considerably at the disaggregate level (e.g. Bils and Klenow, 2004 and Nakamura and Steinsson, 2008), the qualitative and quantitative effects of monetary regime change are likely to be very different across sectors (e.g. Carvalho and Nechio, 2011). A deeper understanding of how regime change influences the dynamics of subaggregate price indices could prove useful to policymakers in a number of ways. For example, it could help policymakers choose an appropriate price statistic for their inflation target by obtaining a better sense of which sectors of the economy might be more affected by policy decisions (e.g. Boivin and Giannoni, 2006, Bryan and Cecchetti, 1994 and Clark, 2001). It may also allow for a deeper understanding of the welfare costs associated with inflation, which have been often linked in the literature to the variability in relative prices (e.g. Choi, 2010).
The primary purpose of this study is to offer some insight into how a change in the monetary policy framework impacts the behavior of headline inflation via its subcomponents. Our analysis centers on two questions: (1) which sectoral prices are more responsive to the change in monetary policy regime, as gauged by three measures of inflation dynamics (level, volatility and persistence) and (2) what sectoral characteristics can explain the heterogeneous responses of sectoral prices. We attempt to address these questions by focusing on Canada's experience with the adoption of inflation targeting (IT) more than two decades ago. As a framework for conducting monetary policy, IT is known to be effective in lowering inflation and inflation variability by stabilizing inflation expectations toward a numerical objective.1 As an early adopter of IT in 1991, Canada has reasonably long time series of price data with which we can compare effectively the periods before and after IT adoption. In addition, the Canadian economy encompasses a diverse range of sectors, with price indices available for a large number of subcategories, enabling a relatively rich disaggregate analysis of the impact of the monetary policy regime change.
A quick glance at Fig. 1 helps grasp important features of Canadian inflation dynamics since 1978. The upper panel of Fig. 1 plots the evolution of the headline inflation rate and three selected disaggregate inflation rates (solid lines) over time, along with the announced target range of inflation (dotted lines).2 National headline inflation displays two apparent structural changes: one around the year 1983 at the end of the Great Inflation and the other around the year 1991, when IT was adopted. The Canadian headline inflation rate fell into the intended target range immediately after IT adoption, indicating the effectiveness of IT in stabilizing inflation. At the disaggregate level, however, the effect of IT is rather mixed. While inflation rates for both goods and services exhibit a very similar pattern to that of headline inflation, energy inflation fluctuates consistently far outside the target range. The heterogeneity in the dynamics of disaggregate inflation can also be seen in terms of volatility and persistence (based on the twelve-month rate of inflation). As illustrated in the lower panel of Fig. 1, energy price changes are much more volatile but less persistent than the others, and do not exhibit a clear response to IT adoption.Further information on the behavior of both headline and disaggregate inflation is provided in Table 1, which lists summary statistics for inflation dynamics before and after IT adoption. To facilitate comparison with earlier studies, we consider two subsamples for the pre-IT period, 1978–1991 and 1983–1991. The adoption of IT was clearly associated with a marked reduction in the level and persistence of headline inflation. The behavior of volatility across time periods, however, is sensitive to the starting point used for the pre-IT period. With 1983 as the starting year of the pre-IT period, we find a slight increase in volatility under the IT regime. This implies that the change in monetary regime was effective in lowering but not necessarily stabilizing inflation.3Table 1 also shows the heterogeneous dynamics of inflation at the disaggregate level highlighted in Fig. 1. Whereas the price changes in food and services became less volatile after IT adoption, energy prices were much more volatile under the IT regime. This very different pattern exhibited by energy inflation is consistent with the conventional wisdom that energy prices are highly susceptible to ever-changing global market factors, and their heightened volatility is believed to be responsible for the failure of headline inflation to fall in the post-IT period. It is also worth noting that energy inflation exhibits qualitatively different patterns than food inflation, although both are major constituents of so-called non-core inflation. Goods inflation also displays a slight increase in volatility under the IT regime, probably in part because of indirect effects of the higher volatility in energy prices on some of its constituents. A similar categorical difference is noted in the effect on inflation persistence, which is known to reflect the formation of inflation expectations (e.g. Amano and Murchison, 2005). The persistence of inflation did fall after the regime change both at the aggregate and disaggregate levels, in line with the basic intuition that a key anticipated benefit of IT adoption is better-anchored inflation expectations. Apart from service prices, however, the persistence of disaggregate inflation was relatively low (below 0.35 in terms of SARC—almost indistinguishable from white noise) even before the adoption of IT. It is the persistence of service inflation that underwent a significant drop under the IT regime, indicative of inflation expectations formation becoming less inertial.The key observation here is that the monetary regime change has affected inflation in different sectors in different ways. What then can explain the observed differences? More specifically, what underlying sectoral characteristics might account for the heterogeneous responses to the policy regime change? While a range of sectoral characteristics have featured in the literature exploring pricing behavior, we focus on price stickiness as a potential candidate for explaining the sectoral heterogeneity given the central role played by the distinction between sticky and flexible prices in macroeconomic models (e.g. Aoki, 2001).4 By relating the degree of price stickiness in the various sectors to the dynamics of Canadian sectoral inflation rates, we find that the degree of price stickiness is positively associated with the volatility, but negatively with the persistence of sectoral inflation, consistent with the growing body of micro-data evidence.
To assess the role of price stickiness in determining sectoral responses to the monetary regime change, we group sectoral prices into two categories, a sticky price category that includes sectors in which price adjustments are made relatively infrequently, and a flexible price category. We construct a summary inflation measure for each category and find strong evidence that the sticky price inflation measure responds very differently to the monetary regime change than the flexible price inflation measure. While sticky price sectors experienced a drastic drop in the volatility and persistence of inflation following the monetary regime change, no such structural change is noticed in flexible price inflation. That is, it is the prices in sectors with less frequent price adjustments that react more strongly to the monetary regime change.
This difference between sticky-price and flexible-price sectors is also reflected in our analysis based on a common factor model, where we decompose sectoral inflation into a part driven by common aggregate shocks (common component) and a part driven by sector specific shocks (idiosyncratic component). The relative importance of common shocks, which is measured by the fraction of the variability of sectoral inflation associated with the common component and labeled as ‘share of common component' throughout the paper, dropped considerably after IT adoption. Moreover, this drastic fall is almost entirely driven by the sticky-price sectors, with the share for those sectors plunging from 26.8% to 3.4%. We find that the decline in the common share in the sticky-price sectors is largely attributable to a reduced sensitivity of sticky price inflation to the common factor. In flexible price sectors, where the share of common component was very low even before the monetary regime change, we notice little change in the share, reinforcing our principal argument that the impact of the monetary regime change was transmitted to headline inflation mainly through sticky-price sectors.
The differing responses between sticky and flexible price sectors to the monetary regime change can be explained by the fact that firms in sticky-price sectors are likely to be more forward looking than their flexible-price counterparts. Because they are slower to respond to changes in the current market environment, firms that adjust their prices infrequently may take more account of the future state of the economy and hence incorporate expectations about future inflation (e.g. Bryan and Meyer, 2010 and Millard and O'Grady, 2012). Given that IT aims to anchor inflation expectations toward a pre-announced target level and that inflation expectations matter more in the sticky-price sector, one may expect sticky-price inflation to be much more responsive to the adoption of IT than flexible-price inflation. In contrast, flexible price sectors are likely to be less affected by IT adoption because they continue to be able to react quickly to sector specific shocks. In this vein, our empirical finding is similar in spirit to that in Carvalho (2006) that sticky price sectors are the main drivers of movements in aggregate inflation, especially in the event of a monetary policy regime change. Our results also support the view of Boivin et al. (2009) that monetary policy regime change is an important contributor to the change in the dynamics of Canadian sectoral inflation, in light of the fact that the dynamics implied by the estimated common factor track very closely the path of short-run interest rates.
The remainder of the paper is laid out as follows. Section 2 describes the data and provides a preliminary analysis of the heterogeneous patterns in the disaggregate inflation series. In Section 3, we sort CPI items into two categories, sticky price and flexible price inflation, to evaluate the impact of IT adoption on the behavior of sectoral inflation dynamics. We construct two sub-indices based on weighted averages of the constituent series in each category and examine the response of each inflation series to IT adoption in terms of mean, persistence and volatility. In the same section, we also implement a common factor model analysis. Section 4 concludes the paper. The Appendix contains a description of the data along with some detailed empirical results at the sectoral level.

نتیجه گیری انگلیسی

In this study, we assess how a monetary policy regime change affects the behavior of headline inflation by focusing on the differential impact across sectors. Our study builds upon a couple of important strands in the empirical literature on inflation dynamics. One strand of the literature has provided pervasive evidence of structural changes in many macroeconomic series, including inflation, after changes in the monetary policy regime. In another, a growing consensus has emerged on the importance of disaggregate analysis in the study of inflation dynamics. Using disaggregate price data for Canada, we examined the impact of the adoption of IT on sectoral inflation dynamics. Our aims were to assess the subaggregate inflation responses to the adoption of IT and to identify the sectors of the economy that were more sensitive to the change in the monetary regime. We found substantial heterogeneity in the responses of sectoral inflation rates, with a pronounced difference in the responses between the sectors in which prices are adjusted infrequently and the sectors with greater price flexibility. The influence of the policy regime change is felt predominantly in the sticky-price sectors of the economy, where firms are more forward looking and hence more responsive to changes affecting inflation expectations. By decomposing the fluctuations in sectoral inflation into a common and a sector-specific component, we also found that one common factor explained about 10% of the variance of sectoral inflation. More importantly, the common component share has declined dramatically after IT adoption, mainly driven by sectoral inflation in the sticky price sectors. Given that the common factor captures aggregate shocks, such as a monetary regime change, and that the dynamics implied by the common factor mimic very closely the dynamics of short-run interest rates, we share the view of Boivin et al. (2009) that monetary policy regime change is likely responsible for the change in the dynamics of sectoral inflation.
Knowledge about the sources of the heterogeneity observed between the sticky-price and flexible-price sectors can be used to guide policymakers when formulating their communication policy, which is an essential tool for effective management of inflation expectations. For countries considering a change to their monetary policy framework, our findings suggest that their ability to predict the impact of the new regime and successfully design a transition to that regime could be enhanced by taking into account the sectoral composition of their economy. For example, if a country is thinking about specifying a numerical target for inflation and its headline inflation rate gives substantial weight to sectors with greater price flexibility, it may need to consider a wider range than normal for its target. This may be a particularly important issue for less-developed countries in which primary resources, whose prices are usually more flexible and thus more volatile, often constitute a larger share of the economy.
While this study unveils several interesting findings, as with any analysis of this kind, it leaves many questions for future research. One potentially fruitful avenue to pursue concerns further exploration of the role of price stickiness in relation to the so-called exchange-rate pass-through (ERPT). Another path might be to examine additional potential sources of the heterogeneity in the responsiveness across the sectors within each price-stickiness category, such as the share of imported content in the goods produced, or the breakdown between durable goods, non-durable goods and services. The current study leaves no doubt that a change in the framework governing macroeconomic policy affects various sectors of the economy differently, opening up many interesting related questions.